This strong finish masked the hit these markets took in late spring, when concerns about economic growth sparked a sharp global downturn. For example, India, one of the hottest markets of 2006, was down 20% at one point during the sell-off but recovered within weeks. India's Sensex 30 exchange has since hit an all-time high. See related story.

"That they were able to shrug it off so quickly and resolutely speaks volumes about investor interest in emerging markets," said Jeff Tjornehoj, a senior research analyst at Lipper. Emerging-markets funds have now rallied for five consecutive years, outdoing almost every U.S. market sector in that time.

The impressive gains extended across many developed markets as well. European region funds rose 33.8% in 2006, while diversified international large-cap core funds gained 24.3%. Only Japan funds suffered, down 3.1% on average for the year.

Border crossings

Brad Durham, managing director at research firm EmergingPortfolio.com, said the market capitalization for countries that make up the MSCI Emerging Markets Index has quadrupled over the past five years to $2 trillion from $500 billion.

Much of that new liquidity stems from the so-called yen carry trade. With interest rates in Japan near zero percent, investors can borrow in yen and move into higher-yielding asset plays like emerging-market stocks and bonds. Concerns that this cheap money will disappear were eased after the Bank of Japan made clear that it will raise interest rates from a zero policy -- in place for six years to stimulate the economy -- very gradually, Durham said.

Moreover, he points out that while some observers fret about the wave of short-term hedge-fund money that is washing over emerging markets, pension funds, endowments and other longer-term oriented institutional investors are providing ballast.

"We're in the middle of a secular trend of more liquidity in emerging markets that is there for a good reason," Durham said. "Emerging markets are benefiting more than developed markets from globalization and will continue to do so unless there is some cataclysmic event that takes place."

But analysts caution that focused country funds are not especially well-suited for most individual investors.

Bill Rocco, senior research analyst at investment researcher Morningstar Inc., said these specialized funds at best should complement a portfolio, not control it.

"Where single-country emerging market funds make sense is for investors who already have a well-diversified set of international funds," he said. "Things can really go wrong for these funds very quickly."

In addition, investors should temper their expectations for international markets over the next couple of years, Rocco said, given the big run these stocks have had.

"It's unlikely that international funds will do as well in absolute or relative terms vis-a-vis domestic funds over the next several years," Rocco said.

Rebalancing act

Investors may want to rebalance portions of their portfolios that have moved beyond their target ranges due to strong international-market gains, Rocco said. Investors who are looking to get exposure to non-U.S. stock funds for the first time should be cautious and make their initial investment smaller, he added.

A core foreign-stock fund is an important part of a balanced portfolio. Beyond that, you can add supplemental position, such as an international small-cap fund or diversified emerging-market portfolio. Also, most individual investors are probably better off with broader and more conservative offerings that can hold up better in volatile periods.

Morningstar makes several recommendations for core international funds.

Investors who already have a core foreign fund might add a secondary or "satellite" fund, such as a diversified emerging markets offering. Morningstar's picks: American Funds New World
NEWFX, -0.98%
and T. Rowe Price Emerging Market Stock
PRMSX, -0.78%

Exchange-traded funds can also provide low-cost exposure to global markets. Alex Young, equity strategist with Standard & Poor's Equity Research Services, said the firm favors ETFs -- index funds that trade like stocks -- for international diversification. He suggests committing 15% of a stock portfolio to iShares: EAFE (which includes companies from developed markets outside of North America)
EFA, -1.12%
and another 5% to iShares: Emerging Markets
EEM, -1.28%

"As long as the global economy is in for a mid-cycle slowdown and not a hard landing or recession, things look pretty good," Young said, "especially given the improving economic fundamentals in Europe, key emerging markets and Japan."

Added Lipper's Tjornehoj: "I think it comes down to two perspectives: If you think that the global economy is headed for a downturn, then the U.S. becomes a great place to hide. But if you don't see a recession in our future, I think the international markets will continue with their present momentum. It depends on your risk tolerance and your horizon."

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